Tuesday, February 28, 2017

Money as layers

Whenever I try to come up with a metaphor for the monetary and banking system I think about the 2010 film Inception, one of my favorite films. After falling into a dream state, the protagonists sedate themselves within the dream so that they can move to an even deeper dream level, and so on; a dream piled on a dream piled on a dream piled on a dream. Conversely, by setting up a series of "kicks," the protagonists progressively wake themselves up from each dream level until they eventually reemerge back in reality.

Like Inception, our monetary system is a layer upon a layer upon a layer. Anyone who withdraws cash at an ATM is 'kicking' back into the underlying central bank layer from the banking layer; depositing cash is like sedating oneself back into the overlying banking layer.

Monetary history a story of how these layers have evolved over time. The original bottom layer was comprised of gold and silver coins. On top this base, banks erected the banknote layer; bits of paper which could be redeemed with gold coin. The next layer to develop was the deposit layer; non-tangible book entries that could be transferred by order from one person to another. Bank customers could "kick" out of their deposits and back into banknotes, and then kick out of banknotes into coin. Conversely, they could sedate themselves from coin into notes and finally deposits.

We can use this metaphor to think about all sorts of things. One of the defining themes of modern monetary history has been the death of the original foundation layer; precious metals. This happened progressively over time as central banks chased private banks from the banknote layer (see here) and then gradually severed the banknote layer from the gold layer. By 1971, thanks to Richard Nixon, there was simply no way to kick out of banknotes into gold. Banknotes issued by the central bank had become the foundation layer. The trend towards a cashless world is a repeat of this script, except instead of the gold layer being slowly removed it is the banknote layer.

Another big story is financial technology, or fintech. For the most part, this has been about improving the various layers. Think about efforts to make the deposit layer more efficient by allowing for more ways for deposits to move, say online payments rather than just cheques, and (centuries before that) cheques rather than the necessity of visiting one's banker in person to issue verbal payment instructions. Fintech is also about improving and increasing the interconnections between layers so that customers can kick/sedate from one layer to another more efficiently. In banking lingo, this is called interopability. So rather than having to wait for a bank teller to move funds from the overlying deposit layer into the cash layer, just go to a machine.

Fintech isn't just about improving existing layers and interconnections, it is also about adding new layers on top of the old layers. As I mentioned earlier, banknotes and deposits were the two most revolutionary layers to be added to the original metal edifice. This happened centuries ago. In modern times, we get technologies like M-Pesa, a third layer on top of Kenya's banknote and deposit layer. Call this the mobile money layer. Kenyans exchange lower-layer units, cash or deposits, at kiosks in return for higher-layer M-Pesa entries. Safaricom, the operator of the M-Pesa layer, keeps these funds deposited in traditional bank accounts, one shilling of bank deposits for each shilling of M-Pesa outstanding. That way there will always be funds available to those who want to kick out of the M-Pesa layer and back into underlying layers. Until then, Kenyans can easily exchange M-Pesa using their mobile phones.

Innovators may run into a tough time building on top of the top-most layer, the bank deposit layer, because banks jealously guard their terrain. Bankers may impede innovators from creating smooth interconnections between new layers and the bank's own layer, thus rendering the kicking/sedation process unattractive for consumers. Alternatively, they may lobby regulators to clamp down on new entrants who are trying to build on top of incumbent layers. In Kenya's case, regulator's allowed M-Pesa to proceed on an experimental basis despite bank attempts to shut it down. In U.K., the Bank of England is considering allowing fintech companies to bypass the banking layer by offering them direct access to the bottom-most central banking layer. This is probably a good idea if innovation is to be promoted.

Bitcoin is unique. Starting from scratch, the Bitcoin movement is trying to erect an entirely independent financial system. Even now there is talk of a new layer being developed on top of the original bitcoin foundation, the Lightning network. The idea here is that the majority of payments will occur in the Lightning layer with final settlement occurring some time later in the slower Bitcoin layer.

The newer "blockchain" movement is taking a different route from the Bitcoin movement and grafting some of Bitcoin's innovations into the traditional financial edifice, the most prominent of these innovations being a distributed method of transferring value rather than a centralized one. How will all this play out? Fintech, which has been going on for centuries, has always innovated within and on-top of the existing system of layers. Off the top of my head, I can't think of a single example of a successful monetary innovation that hasn't developed on top of the existing edifice. Can you? While I love the idea of starting from scratch, monetary history is against bitcoin
and in favor of the traditional banking system. But history has been proven wrong before.

28 comments:

A quasi approach would be when setting up a new currency but even there it has usually been leveraged on that of anothers, so the dollar was originally backed by some British pounds and Dutch loans and new countries often peg to the dollar or perhaps through the IMF or World Bank.

I would say Bitcoin is built off anything that is traded directly with bitcoin (US Dollar, Euro, Stocks, Gold, etc). And with every passing day there are more options. One could say Bitcoin wasn't created from scratch but is built off "old" technology.

Wrt Bitcoin, my reluctance to accept bitcoin is for the same reason. Secondly, I am not a fan of artificially constricting money supply (which gold also caused later) and which Bitcoin will cause sooner or later.

If and when we truly become cashless, then the blockchain technology can help vastly. But used on top of cashless money transfers it makes more sense than on bitcoin.

There's no way to kick out of the banknote layer into the precious metals layer? That's news to me. Why is it that I can easily redeem $1,250 for an ounce of gold at this very moment if I so desired? Granted, the party with which I would redeem my banknotes for gold would be a private gold owner rather than an official monetary authority, but I don't see how that is necessarily an essential distinction.

I very much doubt that we have completely severed ourselves from the commodity-money layer. There is still very much an "invisible gold standard" in effect (and must be for as long as commodity production persists regardless of the legal status of gold), in that investors always have the option of hoarding gold or investing in gold mining, meaning that a gold-zero-lower-bound forms the true hurdle rate to investing in any other type of asset or line of production...meaning that investments must yield profits not just in dollar terms, but in gold terms...or else investors will discover the incentive to hoard gold and invest in gold mining for superior returns.

And if central banks try to increase the banknote supply so as to prop up profits as measured in banknotes, they will find, like they did in the 1970s, that the metallic zero-lower-bound will be there to discipline them, making investors loathe to loan at low interest rates for returns in increasingly meaningless dollars when those investors could just as easily hoard and invest in a gold currency that was appreciating (in dollar terms) at a faster rate than any interest they would reap on dollar loans, even at ridiculous rates as high as 20%.

That is why, in the 2008 crisis, the Federal Reserve had to institute IOER and why they could not react more energetically--why they had to allow a collapse in NGDP. They were fighting a battle not on one front, but on two fronts, so they had no choice. Propping up NGDP more than they did would have led to a repeat of the 1970s--an even worse run on the dollar in favor of gold (as it was, the dollar still faced a run, tripling in price to $1900/oz).

The market monetarists, if they ever get to implement their NGDPLT scheme, are in for a rude awakening to the fact that the commodity-money layer remains very much a player in the world economy, and must remain so as an instrinsic aspect of commodity production. The MMs will find that they will not be able to target NGDP with as much freedom as they would like without occasionally calling the dollar into disrepute compared to the ever-present alternative of gold.

"There's no way to kick out of the banknote layer into the precious metals layer? That's news to me. Why is it that I can easily redeem $1,250 for an ounce of gold at this very moment if I so desired?"

I mean something very specific by that statement. In 1905, an American could bring their paper money to the Fed which would directly redeem it with a set quantity of gold. Nowadays you can of course sell your notes for gold in the open market, but there is no authority that offers a standing offer at a fixed price.

"I very much doubt that we have completely severed ourselves from the commodity-money layer."

The gold layer could of course be restored. A glance at monetary history shows that underlying layers are added from time to time, for instance when a country decides to peg its currency to another currency, sort of like how the Swiss temporarily pegged to the euro layer beginning in 2011.

Beautiful post and great analogy JP, can I put in a request for your take on Aadhaar and IndiaStack? Do you think it's a fundamentally different system or more or less similar to most modern banking systems? Thanks!

To Matthew Opitz: Simple question: why? In pretty much every hyperinflationary environment, no one is turning to commodity money, they're turning to US dollars. Commodity money, in the form of precious metals, persists more as a tradition than as a practical counter balance to fiat currency. .22 caliber bullets are literally better money than gold coins.

Good question. Less volatility, I suppose. Although investors shot themselves in the foot if they fled to cash dollars and low-interest T-bonds in 2008/2009. They would have been much better off fleeing to gold in their flight to safety, as the subsequent rise of gold from ~$650/oz. to $1900/oz. and then stabilization at around $1300/oz. has shown. Even if we avoid measuring trough to peak, that's a doubling in value over dollars. That's what people sacrificed by fleeing to dollars instead.

As for investing in .22 caliber bullets, get back to me the next time .22 caliber bullet appreciate by 4000% over the course of 50 years.

Note that I am not a goldbug. I am not saying that gold will always out-perform other investments. Over that 50-year timespan, investing in an index fund would have offered probably an even greater return.

All I am saying is that it is rational for any investor to measure the profitability of their investments not just against a dollar zero-lower-bound, but a gold-zero-lower-bound as well, because if it looks like the gold profit rate of any investment will be below zero for any length of time, it would be better to hoard gold or invest in gold mining during that span of time.

And you don't need a crystal ball to tell whether an investment is going to make a profit in terms of gold over a given period of time. You just need a keen knowledge of history and a model of certain fundamental factors that would be too complicated for me to go into right now....

JP,Each inception layer is a contract derivative of the more senior layer. Gold is senior to currency, currency is senior to demand deposits, demand deposits are senior to eurodollars, and eurodollars are senior to bitcoin. It's all a question of the promised deliverable.

At each step down in subordination carries greater counterparty risk. Gold has no counterparty risk (as BIS accounting rules specify), US currency is secured by gold and treasury bonds, demand deposits are secured by bank reserves/equity and the FDIC, eurodollars are secured by US demand deposits, and bitcoin is (very arguably) secured by eurodollars.

Another way of saying "derivative" is "leverage". There are a great many of these "deliver USD" contracts outstanding. People consider these subordinated assets to be claims on real commodity wealth. There could easily be a mismatch between the value of these financial claims and real wealth, and one day will be netted out.

The nice thing about commodity money is that it was relatively unleveraged. It matched up the real economy with financial assets almost 1:1. Make no mistake, we're in the midst of a grand experiment in unbacked money and faith in derivative claims.

"Each inception layer is a contract derivative of the more senior layer. Gold is senior to currency, currency is senior to demand deposits, demand deposits are senior to eurodollars, and eurodollars are senior to bitcoin. It's all a question of the promised deliverable. "

Yep, that's another way to put it.

"Another way of saying "derivative" is "leverage". There are a great many of these "deliver USD" contracts outstanding. People consider these subordinated assets to be claims on real commodity wealth. There could easily be a mismatch between the value of these financial claims and real wealth, and one day will be netted out."

Concerns such as these are explain why so many economists have advocated realigning the system of layers (in particular the bank deposit layer), say by imposing some form full reserve banking such as Irving Fisher's 100% plan. Or equivalently Tobin's deposited currency accounts. I've got mixed feelings about these plans.

The money-as-layers is a neat idea and pretty much the way Perry Mehrling prefers to describe the money system: the system establishing a hierarchy of instruments; "credit" at one hierarchical layer/level being "money" for the lower one in the hierarchy. Therefore, there's also a layering of institutions inasmuch as they are issuers of these instruments. And when we consolidate the institutions into one single entity's balance sheet, commodity instruments such as gold appear to remain as no one's liability.

That's why Mehrling seems to want to keep gold in the description. Although I think this involves an assumption where the consolidation of all institutions into one still implies at least two entities so consolidated.

A credit on a ledger describes one side of a relationship, which is balanced by a debit somewhere else in the system. Physical thing / asset, such as gold, does no such thing by itself, even if its market value can be used as a measuring stick for said relationships. Throwing the two into the same ontological pot seems like a a category error.

Oliver, I think you're tapping into the ontological root of the 100% reserve crowd: a categorical separation of commodity money (an asset that changes hands often enough to facilitate other exchanges) from credit money (an obligation made credible by repeated interactions). It follows that one shouldn't be accepted in place of the other. At least not widely.

Yet reality seems indifferent to this separation. The printing of a Federal Reserve note, the ASIC subroutine that mines a new bitcoin, the private database transaction that opens a retail deposit account: all have the observable effect of adding money to an economy, despite the means of origination being so categorically different.

A fascinating part of the story is how each form of money bootstraps its way into general circulation. A commodity can get there by solving coordination problems among market participants (I would argue bitcoin does exactly this for certain state-evading payment and investment use cases, though fewer than Satoshi would have liked); a credit money can get there by public confidence in the issuer's balance sheets; a fiat money has different tools at its disposal, though usually it leaves the bootstrapping part to whatever existing form of money it decides to take over. (Graeber's Debt says this is all backwards: expanded state power begets the credit systems necessary for expanded exchange between groups, and the supposed moneyness of certain commodities ain't got nothin' to say about it.)

If modern credit systems were to truly collapse, the ontological pot would shatter and these various forms of money would lose their par circulation. We'd all wake up from the dream as the 100% reserve crowd insisted all along and never go back to sleep.

The whole point of inception, the twist at the close, is that the ostensibly 'real' layer, which we thought we were levering, cannot be determined as the 'real' layer. It's a choice. It's doesn't matter if it's a commodity, a promise, a big rock, a bit of code. Once the state (the collective) points to it and says 'I demand that' it becomes the real layer. Money dies in revolutions and invasions, not when we wake up to the platonic reality

Well said, Hugo. Money layers can crash from the inside as well: think insolvency, hyperinflation, supply shocks, catastrophic bugs. I think you're spot on about there being no deleveraged reality to wake up to. There never was one. Money is always leveraged upon collectively constructed beliefs about it, and the frailty of those beliefs matters more for money's sustainability than whatever else, real or otherwise, any layer of it might consist of.